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Two-Tier Partnerships Reshape Legal Landscape

From Washington Lawyer, July/August 2014

By Sarah Kellogg

For most of the last decade, American law firms have been wrestling with how best to manage their legal talent in a period of tremendous uncertainty brought on by client discontent, a changing business model, and economic instability on a grand scale.

What had been chronic concerns about managing talent, such as partner staffing levels, escalating compensation costs, and billing rates, turned acute after the 2008 recession. When the economy collapsed, law firms were forced to deal decisively with their financial problems through firm-wide layoffs, withdrawal of offers to incoming associates, and the establishment of more nonequity partnerships to balance their budgets. For many, these dramatic changes signaled the end of the era of law firm largesse, both in terms of finances and talent acquisition and management. The party was over, and law firms quickly moved to consolidate staff and patch the holes left by the downturn.

Today, even with a rosier economy and some equilibrium returning to law practices, the future of law firm talent management remains uncertain. Experts say nonequity partnerships and other human resource solutions cannot erase the thorny problem facing the legal industry: a chronic overcapacity of attorneys wishing to be in a law firm setting.

“In this country, we have built law firms the way [we] build parking lots around shopping centers,” says Ed Wesemann of the global legal consulting company Edge International. “We build them for the three weeks before Christmas [when] the parking lots are full of cars. Unfortunately, the rest of the year the lots are empty. The same is true of most law firms. We’ve got a lot of capacity and not as much need. Something has to give.”

Wesemann and others believe law firms will need to reduce the number of attorneys significantly in the next five years using methods that aren’t nearly as painless as nonequity partnerships. For those firms reluctant to “counsel out” nonproducing partners, a shift is coming and it’s necessary.

The prospect of even more organizational turmoil is uncomfortably close for most firms, even if the magnitude of bloodletting in 2008 won’t be repeated. Many consultants believe the nonequity partnership and the two-tier system it has created will stave off a rash of partner layoffs long enough for attrition to play some role in winnowing the ranks. But there is hard work ahead for firms to adjust to ongoing cultural changes in the legal business.

The growing nonequity partnership tier reflects a fundamental reordering of how legal talent will be managed going forward. The traditional law firm structure made up of equity partners who own the business and equity partners-in-waiting or associates who want to own the business is no longer sustainable. In a marketplace where technology and economics have given clients enormous power to choose law firm winners and losers, an antiquated business model can be lethal to the bottom line.

“There’s a lot of general unease at firms,” says Jeffrey A. Lowe, global law firm practice leader and managing partner at Major, Lindsey & Africa, a lawyer recruiting firm, in Washington, D.C. “In the old days when there were recessions, they lasted a year or two and then firms bounced back to business as usual. Now people see it’s never going to go back to the way it was in 2008. They’re asking how they can be successful in the 21st century.”

“There’s a palpable level of angst among law firm partners and law firm leaders about how to go forward into this decade and emerge as one of the surviving law firms. I think the next 5 or 10 years are going to be transformational in the law industry,” Lowe adds.

However it finally shakes out, nonequity partnership remains a practical interim step for law firms looking to boost profits, manage staff, and salvage parts of the old equity system, even if only temporarily. The challenge for law firm leaders is how best to advance from the two-tier partnership structure to a multilevel talent management system that addresses the needs of both the firms and their clients in the coming decade.

How Law Firms Got HereAs one legal management consultant describes it, the legal profession was the last cottage industry in the United States, clinging to its feudal style of doing business, with partners in the role of manor owners and associates playing the serfs, albeit generally well-compensated serfs. Then, quite abruptly, the biting reality of the 21st century—technological change, demands for increased transparency, and aggressive consumerism—hit, and everything changed.

Clients became more discerning patrons of the law firm product, balking at paying firms’ customary billing rates after years of absorbing high overheads. In-house legal departments commanded transparency in billing rates as well as management reforms, especially in the use of junior associates who were learning on the job but being charged off at high hourly rates.

“We believe that since 2008 when the economy soured, and continuing for most firms to today, clients have exerted an inexorable pressure on rates,” says Kent Zimmermann, a consultant with Zeughauser Group. “That rate pressure has everything to do with the macroeconomy and the clients’ need to save money.”

Decade after decade of firms boldly raising hourly rates with little or no explanation to clients was halted with the onset of this robust consumerism. The same financial stewardship has turned other professions such as medicine into competitive marketplaces where the lowest bidder wins and where reputation is valued, but often is not a final determining factor in their selection.

Meanwhile, technological innovation unleashed a host of consequences on large and small law firms. More and more clients are turning to legal services Web sites for the low-hanging fruit of legal work such as wills, divorces, or simple business contracts. In fact, some large firms even use those same sites to come up with their first drafts of business contracts as they provide basic content quickly and affordably.

In recent years, law firms also have been forced to respond to overall changes in the culture of work. Today, not everyone wants to be in the hothouse environment that is a major law firm, clocking triple-digit weekly hours and being on 24/7 work mode. Other options, such as boutique firms, are viewed as much friendlier to the work–life balancing act, and younger associates and partners—Generation X and Millennials—are more attune to this lifestyle trend, which means it likely will continue, experts say.

Finally, the economics of law is simply forcing changes in talent management. Sure, there was a level of self-indulgence in partner payouts and firm profits in the last 15 years, say observers, but running a law firm requires a certain level of fiscal bravery. The best way to pay the bills is to demand that equity partners become more than attorneys—they have to be business strategists as well. They need to extend their passion for the law to business development. Rainmaking is no longer the bailiwick of a few big names on the letterhead; everyone is required to go out and recruit clients. It is a significant change in the role of partners, and its consequences will likely be felt far into the future.

“One thing is clear, and certainly our partner compensation survey shows, that the thing that matters most these days at most places is your book of business and originations,” Lowe says. “That, over virtually every other factor, dictates whether you’re going to become a partner or nonequity partner. In the old days it would have been enough to be a great lawyer. That’s not the standard we have now.”

A Burgeoning TierIf nonequity partnership appears to be the flavor of the month in legal talent management, it is not surprising. Its growth has been nothing short of remarkable over the last decade, especially among the most prestigious firms. The two-tier system has not only taken hold broadly, it has become a fact of life in the majority of mid-size and large law firms in the United States.

The American Lawyer’s (Am Law) survey of the top 100 law firms in 2013 shows the dramatic growth of nonequity partnerships over the last 20 years. In 1994, the first time the magazine kept records on nonequity partners, there were almost no law firms employing nonequity partners. Today, all but 17 of the top 100 firms have a two-tier partnership system. During that same period, the average number of nonequity partners at a top 100 law firm went from 19 to 141, and 9 firms currently have twice as many nonequity partners as equity partners, according to the survey.

“After 2008, there were firms that hastened the move to grow their nonequity ranks and to shrink their equity ranks to increase profitability,” according to James Jones, senior fellow at the Center for the Study of the Legal Profession at Georgetown University Law Center. “It’s not to say that was all wrong. It is recognizing the fact that in this new era, the legal market has changed, and probably permanently.”

“There will always be a handful of firms at the very top that will probably continue to adhere to the single-tier partnership. It’s one way of organizing things, but there is no longer one way that is going to work for everybody,” adds Jones.

When it comes to organizing principles for law firms, nonequity partnership is not such a horrifying idea, say most experts. It fills a critical role in the complex organizational structure of law firms, and the legal evolution taking place today demands a more nuanced approach, one that can be modified over time to reflect the needs of both attorneys and their clients.

Those in the nonequity partnership ranks are most obviously distinguished from their equity peers in their financial relationship with the firm. Nonequity partners tend to be compensated with a blend of salary and performance bonuses, and they do not have claims to profit shares. They do not make capital offerings to the firm, nor do they shoulder personal liability for firm debts. Some nonequity partners are allowed to participate in partner meetings and have some voting rights, but their input into firm decisions is limited.

As the nonequity partnership tier expanded, the roads leading to it also have multiplied, as have the names describing those under this cohort, which include contract partner, fixed-dollar partner, income partner, non-share partner, and salary partner. Today, nonequity partnership has become everything from a departure zone for retiring partners to a welcoming foyer for arriving lateral hires. As a kind of shorthand, the nonequity tier can be characterized according to three broad categories: a waiting room, a safe harbor, and a warehouse.

The nonequity partners in the waiting room are gifted associates, lateral hires, and retiring partners, and their stay is meant to be relatively brief (several years at the most). The nonequity partnership has always been a favored place for associates with promise to bide their time on the climb to the equity level. The nonequity label is viewed as a respectable way to reward talented associates with the “partner” designation while also giving them time to become seasoned practitioners and go through further evaluation.

Another type of attorney that falls into this category is the lateral hire. After the tectonic human resource shakeout of 2008, lateral hires have become a go-to option for many firms. When they arrive, many law firms have a tendency to place them in short-term, fixed-compensation arrangements to give the new hire and the law firm time to evaluate each other before committing to a capital partnership. (Some big law firms immediately slot lateral hires into equity partnerships, however.) As the number of lateral hires has increased in recent years, their brief stay in the nonequity ranks has become more commonplace.

Finally, there is the senior partner who has decided to pull back on his or her law practice. Few law firms are eager to rush a producing senior partner out the door, and the nonequity position allows for a graceful departure for mandatory retirement while also protecting relationships and reducing disruptions with clients.

Nonequity partnerships in the safe harbor category are those that address a current or ongoing need of the firm and recognize the unique attributes of the attorney. One of the most common examples is the attorney specialist who comes into the firm as a subject-matter expert. These niche attorneys, such as multijurisdictional tax experts or transfer tax specialists, are not required to bring in clients, yet their knowledge is often crucial to the success and operation of the firm.

Another type of lawyer that fits in this category is the attorney looking to take a less active role in the practice for personal reasons, such as to care for a sick child or an aging parent. High-billing senior associates who are not interested in being equity partners often seek out nonequity partnerships, as well. And with the growing pressure to turn every lawyer into a business development expert, many attorneys who want to avoid that responsibility are willing to forego capital partnerships. Treading water in the safe harbor for longer periods of time remains an acceptable alternative, especially in an era where work–life balance is emerging as a factor in the legal industry, a business traditionally immune to those pressures.

“I like the concept of the so-called two-tier partnership because it gives lawyers a lot of flexibility in what kind of professional commitment they desire to make while still being able to call themselves partners,” says Carl Leonard, assistant professor in the College of Professional Studies at The George Washington University and program director of its master’s program in law firm management.

The final category, the so-called warehouse, is the most controversial for employing the nonequity partnership track. Many firms recognize that they are overstaffed at the partner level, yet few managing partners feel comfortable jettisoning their peers, even if they are underperforming. Equity partners who have been de-equitized by the firm due to a failure to meet equity partnership requirements and goals are a growing category of nonequity partners, and one that has the experts worried. In effect, these partners have been demoted, and the nonequity partnership status is a step-down program to their hopefully swift exit. But there is still no guarantee they’ll leave without a push, and consultants believe only financial deficits will pressure managing partners into taking this step. Of course, the danger here is that the nonequity brand becomes tainted inside a firm if the ranks are filled with pricey underperformers.

“Of all these categories, I only have problems with the last one. If a firm decides that an equity partner is not making it, the worst thing the firm can do is keep [him or her] with the consequence of having [that attorney] walking the halls like in the Night of the Living Dead,” adds Leonard.

For individual lawyers, a two-tier system presents an opportunity for them to increase their options inside a law firm. For many years it was clear that lawyers had but one route inside a firm—the partnership track—whether they wanted it or not. There was little flexibility in the kind of professional commitment attorneys could make and still call themselves partners. Today, there are more options for lawyers who want to take a different path, although it often comes with a substantial cost in terms of earnings and prestige.

Short on Strategic PlanningThe two-tier system may have taken hold, but not everyone considers it the right answer to every talent management problem in law firms. Some experts believe it is creating an entirely new set of issues, mostly because the system is poorly managed by law firm leaders.

Moreover, the days when nonequity partnerships were a clever way to increase leverage, ensure higher profits per partner, and keep everyone content inside the firm are slowly disappearing. Most law firm leaders have already recognized that nonequity partnerships are a very temporary patch to more complicated issues and concerns facing law firms.

“Let’s be clear: The reason law firms originally went to nonequity partnerships was to increase their profits per partner and look better in the rankings,” says Robert Denney of Robert Denney Associates, Inc., a Pennsylvania-based legal consulting firm. “This was 20 years ago when they worried more about the rankings and how they were perceived, and nonequity partnerships let them hide a lot of flaws. That still exists today as a reason, but it is not the dominant one.”

A recent survey by Altman Weil, Inc., a law firm management consulting company, found that when discussing law firm talent, firm leaders are most conflicted about their nonequity partnership tier despite the fact that nonequity lawyers led the headcount growth in 2013. The “2014 Law Firms in Transition: An Altman Weil Flash Survey” also showed that some 46 percent of respondents believe they have too many nonequity partners on staff. In 69 percent of firms, less than half of nonequity partners have a realistic chance of ever moving up to the equity tier, the survey found.

“Nonequity partners are needed in some situations, but almost certainly not in the numbers seen in most firms,” wrote James D. Cotterman, principal at Altman Weil, in his commentary to the results of the company’s “2013 Law Firms in Transition” survey. “Law firms need to manage this group with much more attention and discipline, including standards for entry and exit from the tier.”

Chief among the current problems with nonequity partners is the fact that their numbers are ballooning far too quickly, and with an apparent arbitrariness that shows a lack of strategic planning. With no obvious exit points to thin the ranks, the weight of nonequity partner salaries can be a financial drag on the firm. Why? Quite simply, many nonequity partners tend to work fewer hours than associates, yet they are generally paid more. The 2012 Am Law 200 survey showed that there is a significant gap in the average payout per nonequity partner, ranging from $100,000 on the low end to $1.53 million at the top. Equity partners are paid significantly higher than their nonequity counterparts, of course, depending on the law firm.

Reining in the nonequity partnership track will require more aggressive management by law firms, experts say. They need to clearly define the nonequity category, establish standards for nonequity partners, and then create a process to better assess the work of these partners and a system for paying them based on their performance. Most importantly, experts believe firms should establish a ranking system that looks at numerous factors, including expertise, experience, and productivity, in gauging the skills of those in the nonequity level.

“For most law firms, it’s not helpful to have a growing pool of partners who can’t meet expectations for what it takes to be an equity partner,” Zimmermann says. “When you’re trying to recruit strong talent, you want to be around strong talent. You don’t want to be in a firm with a mass of underperformers.”

Another area prime for attention is the need for some consistency in the length of service of those in the nonequity ranks. Some nonequity partners cycle through briefly, others hibernate in the tier for a decade or more. Hence, experts say, that disparity is the reason why law firm leaders need to more assertively manage the ranks and establish clear guidance on the length of service of nonequity partners and conduct evaluations to determine their progress through the system.

Additionally, compensation within the nonequity tier is not clearly delineated. Certainly, lateral hires remain an attractive addition to any law firm and its nonequity ranks, and surveys show most firms are planning to increase their lateral hires over the next five years. Yet lateral hires frequently bring with them a substantial client list and demand higher compensation, even while hovering in the nonequity tier. Mixing in these lateral hires with ascending associates and underachieving former equity partners can cause a wide chasm in nonequity partner compensation.

The two-tier system becomes even more complex when the culture of the firm is taken into consideration. It concentrates capital among a small group of attorneys at the top of the pyramid, where equity partners not only control client business but also determine the firm’s management. It also allows divisions to fester among different partners having dissimilar financial responsibilities. For that reason, two of the country’s biggest law firms, DLA Piper and Akin Gump Strauss Hauer & Feld LLP, switched from the two-tier system back to the one-tier, all-equity partnership track in recent years.

“When you have a one-tier system, everybody has skin in the game,” says Mary Elizabeth Gately, co-managing partner at DLA Piper’s Washington, D.C., office. “You’re investing in the partnership and sharing the risks and benefits. That makes people invest more in the law firm because they have their own capital in the mix.”

Gately says the single-tier partnership track is much more consistent with the firm’s entrepreneurial nature. “The other advantage it has is we don’t have to raise the equity to the same level as we used to, and we don’t have to rely on outside lending when you have partners’ capital,” she adds.

Another concern, one that has dogged the profession for decades, is diversity. The recession prompted mass layoffs, hitting minority and women associates the hardest. Six years after the recession, the number of minorities and women in law firms has yet to recover. For observers, the concern is that equity partner ranks will become more homogeneously white and male, while the nonequity tier will become a mix of women and minority attorneys, if they can even get in.

“We are already seeing stratification and gaps at every level following the recession,” says James G. Leipold, executive director of the National Association for Law Placement. “With nonequity partnership, it has the potential to add another layer where there is disproportionate representation of minorities. We’re already seeing it with the staff attorney designation, which is one area where you’re likely to find African American women gaining in representation as compared to equity partnerships.”

More Changes to ComeNonequity partnerships may not have been conceived to plug a leaking dam, but rather in response to a much needed change to the law firm talent management model, but is it working and will it continue to work? The two-tier system requires law firms to manage these tracks with an eye toward balancing the needs of clients and the firms’ long-term goals, yet it is uncertain whether nonequity partnership can stand up to what comes next, experts say.

“I would describe the industry as in a state of transition broadly,” says Zimmermann, the Zeughauser consultant. “What we’re seeing with resource allocation and how work is getting done promises to present even more opportunities for change.”

For the foreseeable future, the legal staffing model will resemble more a diamond than the conventional pyramid. Instead of a few owners clustering at the top with a mass of associates at the bottom, law firms will have a bulging center of nonequity partners, counsel, and senior associates and a few owner-partners at the top. At the bottom will be a significantly reduced cadre of entry-level associates.

“The legal profession has probably changed more in the last 10 years than it did in the 200 years before that,” says Georgetown Law Center’s Jones. “We’ve solidly shifted from a seller’s market for legal services to a buyer’s market, and one that demands changes to the business model. I don’t expect the changes will end there, though.”

Technology has given rise to virtual law firms, which offer legal services at reduced costs over great distances. Operating from their homes or satellite offices, experienced senior attorneys or respected contractors could deliver top-notch legal assistance to clients at a fraction of the rate of a traditional brick-and-mortar firm.

This practice, along with offshoring or onshoring, will likely grow as technology makes it easier for small firms to compete with larger ones without having to pay for high rents and hire a corps of associates. Deleveraging in this way creates a flat-firm model and a bounty of savings for clients who can take advantage of alternative fee arrangements while receiving the same quality of counsel from experienced attorneys.

The two-tier system may become the second golden age of law, but only after the golden age of equity partners fades from memory, experts joke. In the next decade, law firms will have to grapple with technological advances that have brought other industries to their knees. They also will have to find ways to appease clients and, at the same time, feed their insatiable consumerism. And law firms will have to adjust to the mindset of younger generations of attorneys who refuse to accept the idea that they must give up their lives to have successful careers.

Still, opportunities abound if firms are open to new models. Legal process outsourcing could reduce costs by engaging onshore and offshore outsourcing centers. Such a change might come in the nick of time if clients demand that outside counsel use contract lawyers or third-party vendors to handle mundane tasks. Big Law will feel those changes more acutely than smaller firms, but the tidal wave of better technologies and new staffing models will pave the way for reforms, and the law firms that survive will be forced to accommodate them.

Eventually, market trends will decide the shape of tomorrow’s law firm and its partnership tiers. Big firms, serving what was then perceived as specialized needs of massive corporations without regard to price, have been partly insulated from the fickleness of the marketplace in the past.

In an age where the price of a product and how fast it arrives at your doorstep determine the sale, law firms will have to consider the demand and then construct an entirely new business model to compete at that scale. The two-tier partnership model, with its various idiosyncrasies, may not stand up to the competition, especially if it is poorly managed, but for now law firms embrace it. Only time will tell the future of nonequity partnerships, and which law firms can survive the onslaught ahead, observers say.

“It’s not all bad, and, in most cases, it’s actually good, this market mindset,” says Wesemann, the consultant from Edge International. “It used to be no matter how well or poorly you managed a law firm, you had the same amount of profits. You could throw money out the window and nobody noticed. The result of today’s change is that there are challenges that require more efficient management of law firms, and there is a payoff if you succeed. That seems like a pretty good tradeoff to me.”